Cannabis Tax Audit & Investigations

Cannabis Tax Audits and Investigations: A Strategic Guide for California Cannabis Businesses

The cannabis industry operates in a complex and highly regulated tax environment, with unique tax challenges stemming from the discrepancy between federal and state laws in the U.S. In California, cannabis businesses face rigorous sales tax audits and investigations from both state agencies, such as the California Department of Tax and Fee Administration (CDTFA), and federal authorities, primarily the Internal Revenue Service (IRS). These tax audits focus on compliance with licensing, sales tax reporting, gross income verification, and expense categorization, compounded by the restrictive provisions of IRS Section 280E. At Tax Lawyers Group APC, our Los Angeles-based cannabis tax attorneys specialize in defending cannabis businesses during tax audits and investigations, ensuring compliance while protecting your interests and confidentiality. A comprehensive approach to preparing for and navigating cannabis tax audits plays a critical role due to civil and criminal nature of these tax audits.

Cannabis Tax Audit Landscape

Cannabis businesses face heightened scrutiny due to the industry’s legal complexities. While California has legalized recreational and medicinal cannabis, it remains a Schedule I controlled substance under federal law, creating a challenging tax environment. The CDTFA oversees state-level tax audit and compliance, focusing on proper licensing, sales tax collection, and reporting. Conversely, the IRS concentrates on federal tax obligations, particularly gross income verification and compliance with Section 280E, which prohibits deductions for businesses trafficking in federally illegal substances, except for the cost of goods sold (COGS).

Common triggers for cannabis tax audits include:

• Discrepancies in reported taxable sales or cash flow.
• Incomplete or inaccurate financial records.
• Failure to comply with state licensing or tax reporting requirements.
• Suspected unrecorded sales, especially in cash-heavy operations.

Given the potential for significant penalties, interest, and even criminal investigations, a proactive and strategic defense is essential. Below, we outline the critical steps to prepare for and navigate a cannabis tax audit or investigation.

1. Preparation Before the Audit

Effective preparation is the cornerstone of a successful tax audit defense. Cannabis businesses must anticipate the intense scrutiny of their financial records and operations. Key steps include:

Organize Financial Records

Meticulous record-keeping is critical, especially for cannabis businesses that often handle large volumes of cash transactions. Ensure all financial transactions are well-documented, including:

• Receipts, invoices, and purchase orders.
• Bank statements and cash flow records.
• Inventory logs, including seed-to-sale tracking data.
• Payroll records and vendor contracts.

Using industry-specific software, such as Metrc or other seed-to-sale tracking systems, can streamline documentation and provide verifiable data. Regularly reconcile cash transactions to minimize discrepancies that could raise red flags during an audit.

Understand IRS Section 280E

IRS Section 280E is a pivotal factor in cannabis tax audits. It disallows deductions for ordinary business expenses (e.g., rent, utilities, or marketing) for businesses trafficking in controlled substances, including cannabis. However, businesses can deduct COGS, which includes direct costs like cultivation, packaging, and transportation of inventory. Accurately calculating and documenting COGS is essential to maximize allowable deductions and reduce tax liability. Missteps in categorizing expenses can lead to disallowed deductions and increased tax assessments.

Engage a Cannabis Tax Attorney

The cannabis industry’s legal and tax complexities necessitate specialized representation. A tax attorney with expertise in cannabis law can:

• Navigate the nuances of federal and state tax compliance.
• Protect sensitive information, particularly for business operators or investors acting as proxies for third-party investment firms or individuals who prioritize confidentiality.
• Conduct an internal tax audit to identify and address vulnerabilities before engaging with tax authorities.

At Tax Lawyers Group, APC, we prioritize strict client confidentiality and employ rigorous safeguards to protect your privacy. Our Los Angeles cannabis tax attorneys work closely with you to develop a tailored defense strategy, ensuring compliance while minimizing financial and legal risks.

2. During the Audit

Once a CDTFA or IRS tax audit begins, professionalism, preparation, and strategic communication are critical. While cooperation with the IRS, CDTFA, or California Franchise Tax Board (FTB) is necessary, avoid providing information without consulting your attorney. Key considerations include:

Maintain Professionalism

Be courteous and cooperative when interacting with tax auditors but refrain from sharing sensitive details or engaging in confrontational behavior before consulting your Los Angeles tax attorney. Your attorney can serve as your advocate, handling communications to ensure accuracy and protect your interests.

Know Your Business Operations

Be prepared to explain your business model, particularly how you calculate COGS. Auditors often focus on COGS due to its significance under Section 280E. Provide clear documentation of direct costs, such as:

• Cultivation expenses (e.g., seeds, nutrients, labor).
• Packaging and processing costs.
• Transportation expenses related to inventory.

Your attorney can help you present this information in a way that aligns with IRS guidelines, maximizing allowable deductions.

Provide Comprehensive Documentation

Work with your attorney to compile all requested documentation, including financial records, tax returns, and inventory logs. If you use seed-to-sale tracking software, ensure the data is organized and accessible. An internal audit conducted by your attorney can identify discrepancies or gaps in documentation, allowing you to address issues before submitting to the IRS, CDTFA, or FTB.

Separate Business and Personal Finances

Commingling personal and business funds is a common pitfall that can complicate audits. Maintain separate bank accounts and clearly document business expenses related to COGS. This clarity strengthens your position and reduces the risk of disallowed deductions.

3. Common Tax Audit Focus Areas

Cannabis tax audits typically center on specific areas where compliance issues are most likely to arise. Understanding these focus areas can help you prepare and respond effectively:

Gross Profit and Cash Flow

Tax Auditors closely examine gross profit calculations and cash flow patterns. Discrepancies between reported income and bank deposits or unusual cash flow fluctuations can trigger further scrutiny. Be prepared to explain:

• How sales are recorded and reconciled.
• Sources of cash deposits and their relation to business activities.
• Any legitimate reasons for irregularities, such as seasonal sales or one-time transactions.

Deductions and COGS

Under IRS Section 280E, deductions are limited to COGS, making accurate categorization critical. Auditors will review your expense records to ensure only allowable costs are deducted. Maintain detailed documentation, such as invoices and contracts, to substantiate COGS claims. Misclassifying non-COGS expenses (e.g., administrative costs) as deductible can lead to adjustments and penalties.

Unrecorded Sales

Cash-heavy cannabis businesses are particularly vulnerable to allegations of unrecorded sales. Tax Auditors may compare reported sales to industry benchmarks, bank deposits, or inventory records to identify potential underreporting. Using seed-to-sale tracking systems and maintaining consistent sales records can help refute such claims.

Licensing and Sales Tax Compliance

For California businesses, the CDTFA audits compliance with state cannabis licensing and sales tax requirements. Ensure your business holds valid permits and accurately reports and remits sales and cannabis excise taxes. Non-compliance can result in penalties and jeopardize your license.

Role of a Cannabis Tax Lawyer:

Our Los Angeles cannabis tax attorneys bring specialized expertise to defend your business during tax audits and investigations. We understand the unique challenges of the cannabis industry, from Section 280E restrictions to the need for confidentiality. Our services include:

• Pre-Audit Preparation: Conducting internal audits and organizing financial records to strengthen your position.
• Strategic Representation: Negotiating with the IRS, CDTFA, or FTB to minimize liabilities and secure favorable outcomes.
• Confidentiality Protections: Safeguarding sensitive information for operators and investors seeking privacy.
• Comprehensive Solutions: Exploring additional tax relief options, such as penalty abatement or installment agreements, to resolve your tax issues.

Consultation RE: Cannabis Tax Audit

A cannabis tax audit or investigation can be daunting, but with the right preparation and representation, you can protect your business and achieve a favorable resolution. We are committed to guiding you through every step of the process with expertise and discretion.

Contact us today to schedule a confidential consultation. Our Los Angeles cannabis tax attorneys will review your case, assess your financial records, and develop a tailored tax defense strategy. Call (310)788 9820 or visit us online to get started.